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Our latest asset allocation view

byJohn Redwood

When the Charles Stanley Investment Strategy Committee met to review the outlook, several of the main worries that had dominated our discussions in the second half of last year had diminished.

The slim possibility of a major Euro-crisis born of the dispute between Italy and the EU over the Italian budget has receded, thanks to a compromise over the size of the deficit Italy will be allowed this year. As expected, in a European Parliamentary election year, the Italians have been allowed some slack to spend a bit more and borrow a bit more despite their very high levels of existing borrowing.

The US Federal Reserve had some change of heart over three more rate rises in 2019, and has started to move its language away from further monetary tightening to some soul-searching over whether it has already tightened quite enough. The biggest single force pushing markets down at the end of last year was the feeling that combining several rate rises with quantitative tightening, taking money and bonds off the Fed balance sheet, was going to slow the economy too much. The more the Fed relaxes its stance, the more share prices should respond favourably.

Even the trade arguments between the US and China look as if they may be entering a more productive phase, with both sides in talks and wanting some kind of deal. President Trump may posture further, but is clearly rattled by the negative response of equity markets to Fed action and his trade rhetoric. He has shifted his stance a bit from denial that tariffs and trade threats can slow growth to some recognition that damage can result. President Xi also looks like a man who wants to stop further declines in the growth rate of his economy, and may be willing to do a deal now with the US as long as there is no suggestion of a Chinese capitulation. China is loosening policy a bit, worried about the domestic slowdown.

The partial lifting of all three of the main threats to world growth and some lifting of pessimism implies that share values are now attractive again, after the sharp falls of October and December last year. The recent rally shows the mood is improving a bit. The Strategy Committee, however, felt the need to examine further possible bearish influences on share markets which have emerged from the events of recent weeks.

The first is company earnings. The slowdown of growth in the US, the more pronounced slowdown in the Euro-area, and the spate of poor figures coming out of the Chinese economy, all point to a collapse in the lively rate of earnings growth, with some analysts now anticipating earnings falls in some areas.

The second is the possible knock-on of higher interest charges in the US and slower growth in turnover and profits leading to more companies being downgraded by credit rating agencies. This not only produces a sell-off in the company’s bonds, but could be a negative for the shares as well, given the way markets discount the higher chance of complete business failure. Some of the groups most at risk are being destabilised by the rapid pace of change from the digital revolution. Traditional retailers on both sides of the Atlantic, for example, are vulnerable to downward rating changes as their reduced turnover and profit is made worse by the high costs of maintaining their large store estates in the face of internet competition.

The third is the continuing risk of policy error by Central Banks or by China and the US in their wide ranging dispute.

Finally is the likely increase in political risk in Europe in the run up to the European Parliamentary elections. Mr Trump himself has started to mention unfair trading practices by the EU again, which could herald an unwelcome extension of his trade row to include the European food and car markets.

It looks as if the next European Parliament to be elected in May will see a substantial decline in representation from the traditional centre-left and centre-right pro-EU groupings, with many more populist radicals of right and left who want to change the EU or in some cases want their countries to leave it or the Euro altogether. There will be pressures for some reflation to tackle the slowdown on the continent, but there will also be some worries about challenges to the disciplines of the Eurozone.

The Committee decided to respond to the reduction in fears about a general monetary crunch by recommending a switch of some money out of developed markets into China and emerging markets, as they look good value. The action being taken in China to improve the outlook comes after a major fall in the stock market, and at a time when there are some signs of a possible resolution of the trade issues with the US.

The Committee also raised the chances of a worse outcome for shares generally from 25% to 30%, given the earnings slowdown. The base case with a 60 % probability looks forward to moderate growth and a reasonable outlook for shares which offer good yields compared to bond interest rates in the advanced world.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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